Study notes

Balance of Payments

The balance of payments (BOP) records all financial transactions made between consumers, businesses and the government in one country with others

  • The BOP figures tell us about how much is being spent by consumers and firms on imported goods and services, and how successful firms have been in exporting to other countries.
  • Inflows of foreign currency are counted as a positive entry (e.g. exports sold overseas)
  • Outflows of foreign currency are counted as a negative entry (e.g. imported goods and services)

The balance of payments is made up of these key parts

  • i) The current account
  • ii) The capital account
  • iii) Official financing account

(Note: You will need to understand all three for A2 exams, the AS course focused only on current account)

Stylised Example of the Balance of Payments

The example below refers to a hypothetical country, data is in $ billion

Item of the BoP Net Balance $ billion Comment
Current Account
(1) Balance of trade in goods -25 A trade deficit
(2) Balance of trade in services +10 A trade surplus
(3) Net investment income -12 Net outflow of income i.e. due to profits of transnational corporations
(4) Net overseas transfers +8 Net inflow of transfers perhaps from remittance payments from migrants
Sum of 1+2+3+4 = Current account balance -19 Overall – this country runs a current account deficit
Financial Account
Net balance of foreign direct investment flows +5 Positive net inflow of FDI
Net balance of portfolio investment flows +6 Positive net inflow into equity markets, property etc.
Net balance of short term banking flows -2 Small net outflow of currency from country's banking system
Balancing item +2 There to reflect errors and omissions in data calculations
Changes to reserves of gold and foreign currency +8 +8 means that this country's gold and foreign currency reserves have been reduced
Overall balance of payments 0

Key point:

If a country is running a current account surplus, this means there is a net inflow of foreign currency into their economic system. From a balance of payments point of view, a surplus on the current account would allow a deficit to be run on the capital account. For example, surplus foreign currency can be used to fund investment in assets located overseas. The balance of payments must balance.

Countries with current account deficits can run into difficulties. If the deficit is large and the economy is not able to attract enough inflows of foreign investment, then their currency reserves will dwindle and there may come a point when the country needs to seek emergency borrowing from institutions such as the International Monetary Fund. Trade deficits and the resulting borrowing lead to a rise in external debt.

Examples of inward FDI for the UK - an inflow of capital on the capital account of the balance of payments

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